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Special Topics cont.

Special Topics cont. Week 13. Case Study: S&L Crisis. Background: Oil crisis in 1970’s Inflation High interest rates Problems for depository institutions. What was the problem …?. Spread based banking: lending long, borrowing short. Regulation Q (price ceiling on interest on deposits).

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Special Topics cont.

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  1. Special Topics cont. Week 13

  2. Case Study: S&L Crisis Background: Oil crisis in 1970’s Inflation High interest rates Problems for depository institutions

  3. What was the problem …? • Spread based banking: lending long, borrowing short. • Regulation Q (price ceiling on interest on deposits). • Disintermediation (savings going into direct finance process)

  4. Interest Rate Risk Risk associated with borrowing short and lending long. If interest rates rise, liabilities will be turned over at new higher rates while the bank is still earning low rates on assets.

  5. S&L’s hit hard … S&L’s were given incentives to finance home ownership. Well diversified against CREDIT risk but not INTEREST RATE risk. Why not?

  6. Capital shortage … FSLIC (Federal Savings and Loan Insurance Corporation) should have shut down insolvent S&L’s and paid off depositors. It didn’t. Why not?

  7. Regulatory Forbearance Looking the other way. Loosening regulations. Hoping S&L’s would turn themselves around. Huge MORAL HAZARD problem. Long bomb strategy.

  8. Zombie S&L’s Dead (insolvent) Living (still in operation) Killing the healthy (offering high rates to lure depositors away)

  9. Corrupt practices … • Buy insolvent S&L for next to nothing. • Lure depositors with incentives. • Lend money to cronies. • Example: Castle Grande trailer park in Arkansas

  10. Financial Institutions Reform, Recovery, and Enforcement Act (1989) • FSLIC closed down. • Resolution Trust Corporation to close down S&L’s and pay off depositors. • Total cost to taxpayer: $150 billion.

  11. Managing Interest Rate Risk

  12. Managing Interest Rate Risk Keep track of the gap = rate sensitive assets – rate sensitive liabilities Loan sales Fee income Derivatives (financial contracts as insurance)

  13. Calculate the 1-year GAP (RSA-RSL) (300+100)-(10+90+160+200+200) = -260

  14. Loan Sales • Longer term loans are sold reducing the gap. • Loans are often securitized—packaged into securities to be sold to investors. • Example: mortgage backed securities.

  15. Derivatives • Financial futures. • To hedge an interest rate risk find a derivative whose value increases when interest rates rise (or when bond prices fall.)

  16. Banking Industry Structure and Competition Chapter 10

  17. Historical Development of the Banking Industry Outcome: Multiple Regulatory Agencies 1. Federal Reserve 2. FDIC 3. Office of the Comptroller of the Currency 4. State Banking Authorities

  18. Dual Banking System State chartered banks operating along side nationally chartered banks.

  19. The Decline in Banks as a Source of Finance

  20. 8,000 commercial banks in U.S. vs. a handful in other countries. Why? McFadden Act (1927)

  21. Reasons for consolidation • IT • Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

  22. Bank Consolidation and Number of Banks

  23. Separation of Banking from other Financial Services Industries • Glass-Steagall Act 1933 • Gramm-Leach-Bliley Financial Services Modernization Act of 1999

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